Bill Guerin, Jakarta – Indonesia's macro indicators are probably better today than they have been at least since the Asian financial crisis of 1997-98 wrecked the economy. So, despite President Megawati Sukarnoputri's March declaration of 2003 as the Year of Investment, why aren't foreign direct investors beating a path to Southeast Asia's biggest economy, the fourth-largest country in the world by population?

A rock-steady rupiah, macroeconomic stability, substantial foreign-exchange gains, manageable inflation, reduced external debts and a shrinking budget deficit have not been enough to turn the tide. Ingrained perceptions of country risk or, more accurately, risks continue to haunt an administration facing elections next year.

Amid positive news, including a sovereign ratings upgrade, a planned bank sale and the latest International Monetary Fund (IMF) loan disbursement, the Jakarta Composite Index (JCI) extended gains last week to end at its highest in more than three-and-a-half years.

The government announced that it would offer 45 percent, not 30 percent, in its forthcoming public offering for shares of the country's fourth-largest bank, Bank Rakyat Indonesia (BRI).

Last week the IMF granted a US$493 million loan payment, the second-last payment under the $5.2 billion facility.

Key indicators in the 2003 budget have been surpassed. For example, the budget set an inflation target of 9 percent for this year, against 10 percent last year. But after peaking at more than 15 percent in early 2002, inflation is now running at an annual rate of 6.2 percent, the lowest in the past three years, and is predicted to fall to about 5 percent by year-end.

The rupiah, one of the best-performing currencies in the region this year, now trades at about 8,380 to the dollar, against an average 8,900 assumed in the budget despite significant declines in key policy interest rates and official exchange-rate intervention by the central bank. Interest rates are now reaching historic lows as the lower-than-expected inflation allowed Bank Indonesia, the central bank, to cut its benchmark one-month SBI interest rate to 8.53 percent. This year's budget forecast a rate of 13 percent.

So what's the trouble? In a word – or several – fiscal and corporate debt, unemployment, security and corruption, and a lack of government will to do anything about them.

A third of Indonesia's budget goes for debt service. The country's massive deficit, projected for next year at 77 percent of gross domestic product (GDP), is a fundamental problem dating back decades to the time when Megawati's father Sukarno was in power. It has left a legacy of inflation and robbed the country of development funds because of the necessity of debt payment.

The total national debt stands at almost $130 billion, with more than $70 billion owed by the government, and the rest by local companies. Successfully restructuring these billions of dollars of foreign debt without an IMF program will incur a significantly higher cost. Interest rates will be less favorable than could have been negotiated under the IMF umbrella.

The central bank has said total debt maturing this year alone will reach $18.5 billion, although some companies are still trying to roll over the maturities. Debt repayments of $5.16 billion in 2004 will exert pressure on the balance of payments. Interest charges for this debt badly impact on the country's finances. This interest cost wastes large portions of the taxpayer's money without producing a single thing: no goods, no jobs, and no infrastructure – it is money thrown away.

The budget deficit last year was a mere 1.6 percent of GDP, but the deficit policy itself is often criticized.

When Sukarno was in power, excessive government spending led to hyperinflation of more than 700 percent annually. During Suharto's rule a balanced budget was government policy and the development portion was upped every year to support growth, though revenues from the fiscal sector were constantly insufficient to finance this need.

The deficit had to be covered, mainly by borrowing from donor countries in the Consultative Group on Indonesia, and the borrowing only sustained the relentless cycle of debt. The economy did not have enough capacity to generate sufficient output and revenue to service these debts.

The same is happening now. The government no longer has the money to support infrastructure development, so private-sector funds are increasingly vital. Though the financial sector and the capital market are recovering, most of what new money there is coming onshore is not direct investment (FDI), badly needed to stimulate the expansion of an economy that, though on a path of modest growth, has achieved an annual equivalent of only 3.8 percent so far this year. Indonesia was the only one of the 10 Association of Southeast Asian Nations (ASEAN) member states to record negative growth in FDI inflow in 2002, while Malaysia, by comparison, achieved a record 478 percent jump in FDI inflow.

Indonesia's FDI inflows are thus not sufficient to deal with the massive unemployment problem. With some 9.1 million out of work and an annual influx of 2.5 million new entrants to the labor market, analysts say annual growth of at least 6 percent is needed. GDP growth of 5.4 percent is the average forecast for next year, and this will still depend heavily on domestic consumption, as has been the case since 2000. Domestic consumption contributes about 75 percent and investment 15 percent to the country's GDP, according to the Central Statistics Agency (BPS).

While the attractions for foreign investors are an enormous labor force, still at the cheapest rates in the region, and an abundance of natural resources rich for exploitation, investors are frightened off by labor disputes that can result in the closure of a plant and by the ease with which they can lose court actions.

Part of that results from a controversial new labor law passed in June that not only managed to alienate most trade unions but also, more damagingly, was widely seen as one of the most anti-business acts in the region.

A warning came from Bank Indonesia last weekend via its latest report, which said that the consumer confidence index – which measures the public's perspective on the economy – declined in August to 76.3 from 81.8 the month before. The rising pessimism reflects people's declining confidence in the prospect of family income, the central bank said.

According to a recently released White Paper, the government will seek to reform the industrial and trade sectors and will attempt to improve the judiciary and law enforcement in cases involving corruption.

As regards corruption, the Berlin-based Transparency International has once again ranked Indonesia as one of the world's most corrupt nations and alongside poorer African countries in terms of investment climate. It cites widespread graft in the public sector and judicial system when ranking Indonesia almost at the bottom of a list of 103 corrupt countries, only slightly better than Myanmar, Angola, Cameroon, Paraguay, Nigeria and Haiti.

Indonesia's score of 1.9 out of 10 prompted Teten Masduki, coordinator of the Indonesia Corruption Watch (ICW), to point out that all this was hardly surprising as "widespread corruption can be seen at every level". He said the country "desperately needs a leader who has a solid track record and high integrity".

The economic package outlined in the White Paper, a blueprint for a post-IMF future, sets out a series of time-defined targets for specific economic actions to be undertaken by the government. The targets under the IMF programs were quantifiable and easily measurable, but analysts say the lack of concrete targets to measure the success of the proposed actions casts some doubt that Indonesia will maintain the fiscal discipline needed to continue its recovery and improve its credit rating. They cite lack of clarity in the outlining of policies to boost investment, exports and employment.

Early signs are hardly promising. The government simply abandoned programmed subsidy cuts agreed with the IMF, in order to halt further fuel and electricity price hikes this year as election campaigns get under way.

Oil prices on the international market increased to an average level of $26.50 per barrel, compared with the budget assumption of $22 per barrel. This means higher spending on fuel subsidies, which, the government says, could increase to Rp25.6 trillion ($3.04 billion). Even with windfall profits from higher oil prices on the international market it still leaves a further deficit of Rp5.5 trillion.

Investors were showing serious interest in the mining, oil and gas, banking and telecommunications sectors before the bombing of the Marriott Hotel on August 5. Though the impact on the economy has been minimal, the effect on the investment climate is still uncertain.

Security problems, problems with legal reform, bureaucracy, corruption, political inaction, labor issues, and so on feed the negative perceptions of Indonesia in investors' eyes. Warnings that, as Al-Qaeda plans new suicide hijackings and bombings in the United States and abroad, Indonesia is a prime target because of its relatively lax security and the presence of radical Islamic groups badly affect sentiment.

However, the 2004 election, economists predict, will be great for the economy. An expected rise in money supply and likely high spending in the state budget during the early post-IMF period are expected to have a positive effect on the economy. A burst of consumption as political parties spend big money on their campaigns should boost consumer spending dramatically, as happened in the last election year. It was the single factor that kick-started the economy in 1999. Continued lowering of interest rates should also fuel private consumption.

Some analysts suggest that in the run-up to the election, investment inflows will come mainly from privatization of the remaining state banks and other state assets. Certainly the Indonesian Bank Restructuring Agency (IBRA) has made good progress in restructuring and selling assets the government took over in the wake of the regional financial crisis. But IBRA is winding down to the end of its tenure, and evidence suggests that the remaining weak state banks will eventually get a government bailout, come what may, adding more costs to the taxpayer.

Standard & Poor's (S&P) last week upgraded Indonesia's long-term foreign and local currency ratings slightly, reflecting fiscal performance but warned, "The ratings on Indonesia are constrained by political uncertainty." Nothing new there, though perhaps a tad unfair given that the Abdurrahman Wahid administration that preceded this one had been noted for frequent cabinet shuffles and slammed for lack of consistent policies.

The ratings boost followed a government announcement that it is planning to issue global bonds next year, the first since the crisis, to help finance the budget deficit, estimated to reach Rp24.9 trillion, or some 1.2 percent of GDP. Coordinating Minister for Economic Affairs, Dorodjatun Kuntjoro Jakti, however, conceded that the new debt rating, five notches below investment grade, had yet to reach a level that would encourage significant investment,

Investment Coordinating Board (BKPM) chairman Theo Toemion will propose a new investment law to the House of Representatives in December that would allow foreign investors to put their money in almost all sectors of the economy, apart from the defense sector, small and medium-sized businesses, and sectors related to religion. These sectors will be all that remains of the once-expansive negative list of areas forbidden to foreign investors.

Toemion said at the ASEAN Business and Investment Summit in Bali last week that at as of October investment in the country had been $10 billion this year, of which $5 billion was foreign investment.

"We have concluded that short-term investment will be dangerous and without added value. But in FDI, they [investors] bring in the capital and build the factories so that they will not immediately flee when a crisis occurs," Theo said.

That, of course, is the point. Divestment of state-owned enterprises and restructuring of IBRA assets by new investors should result in a flood of new money into Indonesia, a boost in job creation and an improvement of corporate governance. Encouraging quality investors back in would also kick-start moribund industries and revive the industrial sector, as well as bringing badly needed management skills to protect their investments.

Some 576 new projects and 181 expansion projects worth $5.02 billion were approved, an increase of 23.4 percent from $4.07 billion over the same period last year. However, the reality behind these figures is that many of the projects were status changes from domestic investments to foreign investments (thus largely formalizing capital investment already approved).